Tuesday, October 25, 2011

Oil Prices, Recession & CAD

Many oil market analysts have argued that a backwardated market is a bullish signal because it suggests tightness at the front end of the market. The other side of the debate (which is where we land) is that a backwardated market is one in which market players believe prices tomorrow will be weaker than they are today. The last time we were in a backwardated market was in late September/early October 2008 when prompt oil prices were trading between $90 and $100 per barrel. Three months later we touched a low of $32.40.

 Ok so the bread and butter of the CAD is oil prices -- specifically oil prices priced in the WTI (don't know why there is high correlation with that index -- and not Brent or West Coast...).  Barckwardation is an anomalous condition in physical commodities it can be caused by two distinct reason:  funny enough at either extreme of the economic cycle.  First high spot price are based on a view that supply is tight, in a rising demand environment (Economic growth) will lead to rising supplies (eventually) hence forward prices are lower.  The other argument is that future prices are lower because there is an expectation of demand collapse -- caused by recession.

ECRI's model assumes that America is on the verge of a recession (the last time they predicted a recession was in 2007) and they have an excellent track record.  The other reality is that with the Greeks, Portuguese, Irish, British, Spaniards and now Italians all cutting government spending, a recession is a given in Europe.  Governments account for a much larger percentage of GDP in Europe (in France, government expenditure accounts for 42% of GDP).  Italy and Spain are the only two economies that matter here with 12% and 8% of Europe total GDP -- a cut in their growth rate will be felt accross Europe.

News out of China are not good, everyone in the business is "praying" for a soft landing there, but it is hard to imagine how the Chinese government could orchestrate such an outcome, especially since inflation remains a stubbornly high!  A hard landing in China, a recession in Europe and America would spell doom for oil prices -- maybe not into the $40/bbl range but it could easily drop by 30% or 40%.  

Needless to say that a multiple recessions across the planet would have a negative impact on the CAD, on our exports would suffer (obviously).  


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